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What the heck is up (or down) with oil prices?


The hybrid car I drive sips gas. It rarely costs more than $35 to fill the Prius, so I'm never so shocked by price fluctuation at the pumps.

But, as an investment analyst who keeps tabs on global oil markets, the volatility of oil prices over the past month has been a head-turner.

Over just a few weeks, U.S. benchmark oil prices toppled close to a third from four-year highs. A few months ago, media speculated that oil would top US$100 per barrel; today it trades at closer to US$50.

And it's looked worse in Canada, where Alberta crude oil prices touched historic lows last month.

So, what's up with oil prices?

Earlier this year, our view was that oil prices were superficially high. After the recent decline, we now expect prices to moderate back up, along with supply-side changes.

What we mean when we talk about “oil prices"

Different grades of crude oil–the thick, unprocessed stuff—price in factors like ease of refining, location, ease of transport and pipeline capacity. Geopolitical events and sentiment also drive prices.

Two key global benchmarks we watch are West Texas Intermediate (WTI) and Brent crude from the North Atlantic. These are “light" (low density) and “sweet" (low sulfur) grades, good for gasoline refining.

Canada's oil sands produce “heavy" (high density) and “sour" (high sulfur) crude oil. It costs more to refine this into an end product, so it's priced less favourably.

The Western Canadian Select (WCS) benchmark is quoted as a spread relative to WTI prices. That margin has been about -$15 per barrel, on average, over the past 10 years. In July, WCS dipped to -$20, sliding to a record low of -$50 in October, before easing back.

Why are Canadian oil prices so low?

Oil production in Canada hit a bottleneck, as rising supply surpassed pipeline and transportation capacity. The Alberta government and federal government have been reviewing options, including production cuts, but producers are divided.

One cause is temporary, but could persist for months: several key U.S. oil refineries have shut down for maintenance, holding up Canadian exports.

And a lack of clarity around future pipelines is affecting market sentiment about landlocked supply, as TransCanada Corp.'s Keystone XL oil pipeline awaits environmental review and the Trans Mountain Expansion Project is in hearings for reconsideration.

The markets have seen supply-side pessimism

Globally, WTI prices had been on a steady rise since June 2017, peaking at US$76.41 in October 2018. Fears of supply shortage helped boost prices early in the year, as markets expected fallout from Venezuela's economic collapse, U.S. sanctions on Iran, and the outlook on Russian and Saudi Arabian oil production.

By early October, data from the International Energy Agency showed crude oil supply surpassing demand, a trend that has continued. This calmed supply fears but hurt prices. The Trump Administration wavering on sanctions against Iranian oil export led to further decline.

Why we're cautious, but not concerned

Our analysis suggests recent oil prices have been driven more by supply-side dynamics than demand-side factors, which would be of greater concern. The probability of recession remains low over the next 12 months, and we don't see oil demand weakening.

Negative sentiment led major oil benchmarks to trade below true value, and we expect current prices to rise as production is curtailed in response to the lower prices. There is higher volatility due to geopolitical issues, and we think long-term oil prices will be range-bound.

For Western Canadian Select, there's no quick solution. We expect the larger than typical discount to persist into 2019. Oil remains an important part of the world economy, and MD's exposure to energy is different for each fund and portfolio in our roster.

In MD's alternative investment funds and pools, we've recently moved to an overweight on oil (WTI). In the MD Global Tactical Opportunities Pool we've been increasing our position to Canadian equities over the last year as oil prices rose and the domestic economy strengthened, but remain underweight at this time. We continue to monitor the impact of WSC pricing trends.

Our Canadian equity funds typically have a material allocation to energy, as the sector represents about 20% of the S&P/TSX. The MDPIM Canadian Equity Pool and the MDPIM Dividend Pool have exposures of 16.5% and 9.5% respectively.

Meanwhile, back at the pump

I'm not sure when I'll be back at the gas station. The Toyota gets such great mileage, it can be weeks between fill-ups.

However, analyzing oil benchmarks and market trends IS part of my daily routine, as a member of the MD team that monitors and assesses risks and opportunities in the markets.

While I hope this helps explain some of the ups and downs of oil prices, if you'd like to hear more detailed analysis on this, or anything else, please just ask your MD Advisor.